E*Trade's Caplan took brokerage into banking, mortgage risk

JedHorowitz

(This article was originally published Monday.)

NEW YORK (MarketWatch) -- Mitchell Caplan has been building up E*Trade Financial Corp.'s
ETFC, +0.65%
consumer lending business since the day in 2000 when the discount broker bought his phone-based banking firm, Telebank.

Caplan preached the gospel of balancing the volatility of stock brokerage with the stability of a retail banking business that took deposits and made higher-interest loans. And until this summer, his plan seemed to be working.

The strategy produced four years straight years of record revenue that stretched from 2003, when Caplan was promoted to chief executive, through the end of 2006. In January, the Wharton School of the University of Pennsylvania published a glowing article in Knowledge@Wharton, "How E*Trade's Caplan Brokered a Turnaround for a Once-doomed Company."

But Caplan's strategy, which took E*Trade into mortgage lending, started looking shaky in July, when credit markets shuddered following the collapse of two Bear Stearns Cos. (BSC) hedge funds that were deeply invested in mortgage-backed securities. And Friday, the bubble burst for E*Trade.

Risk Management Criticized

In a filing with the Securities and Exchange Commission, the firm said it was reneging on the 2007 earnings outlook it had given less than a month earlier. "Investors should no longer expect these earnings levels to be achieved," the company wrote, and should expect "further securities writedowns in the fourth quarter. E*Trade blamed continued declines in the value of its $3 billion portfolio of asset-backed securities, which contained complicated instruments called collateralized debt obligations and securities backed by second-lien loans.

E*Trade also said the Securities and Exchange Commission has opened an informal inquiry related to issues with its loan and securities portfolios.

What shocked investors is that E*Trade's direct discount brokerage competitors have reported no such problems. The emerging picture is one of a firm that moved too aggressively into businesses and risks that left it hamstrung when the markets turned.

"That peers have virtually entirely avoided the credit crisis again highlights the flawed strategy and lack of credible risk management by E*Trade's senior executives and the board of directors," Citigroup analyst Prashant A. Bhatia wrote in a note to clients Monday.

Traders erased more than $2 billion of E*Trade's market capitalization Monday - more than half its market value - after Bhatia warned the company's disclosure could spark a run on the bank that could threaten its viability. E*Trade shares plunged 59% to $3.55, leaving the stock off more than 80% on the year. Shares of competitors Charles Schwab & Co.
SCHW, -0.61%
and TD Ameritrade
AMTD, -0.75%
by comparison, closed higher Monday and are up 21% and 17% so far in 2007.

"The continued negative news flow about charges resulting from its mortgage and CDO exposure, an SEC inquiry, and continued deterioration in its financial condition, all increase the likelihood of significant client attrition," Bhatia wrote. Other analysts, including Fox-Pitt Kelton's David Trone, thought a bankruptcy unlikely.

In a letter to customers Monday, E*Trade Chief Operating Officer Jarrett Lilien said the firm continues to be "well capitalized by regulatory standards" and could absorb an immediate write-down of over $1 billion.

"Nobody knows for certain what the ultimate impact will be from these markets, but it is our expectation that news in the market will get worse before it gets better and, armed with these expectations, we are taking prudent measures to effectively manage the company's balance sheet," Lilien wrote.

Like many larger financial companies - including Citigroup Inc. (C), Merrill Lynch & Co. (MER) and Morgan Stanley (MS) - E*Trade said it was sideswiped by rating agencies' decisions to downgrade many triple-A rated CDOs to junk. E*Trade had about $50 million of such downgraded securities among its $450 million portfolio of CDOs and second-lien mortgage-backed securities.

CDOs combine slices of different kind of risk and are often backed partly by subprime mortgages, or loans given to customers with poor credit history. In addition to holding some investments in CDOs, E*Trade's asset management unit manages some. Fitch Ratings on Monday downgraded its assessment of the unit's management abilities.

"Fitch's rating action takes into consideration publicly reported changes in E*Trade Financial's business strategy that give rise to concerns regarding the match between the organization's current competencies and wherewithal with the execution of the firm's CDO investment management mandates," Fitch wrote.

Building A Banking Arm

CEO Caplan started with E*Trade as its chief banking officer, charged with baby-sitting a small subsidiary that took deposits and made home equity and other loans to brokerage firm customers. He ascended to president after helping to oust his free-spending predecessor, Christos Cotsakos, and developed what became known as E*Trade Bank from a mere appendage of the core online brokerage business to its equal.

E*Trade's revenues tell the tale of the change in focus. Equity trading commissions, which at the height of the dot-com boom in 2000 provided more than 60% of the company's revenue, fell to about 15% last year, when net operating interest income, the motherlode of consumer banking, crested at more than half of the company's revenue.

Caplan took over as president in 2002, when E*Trade's shares sunk below $3 from a high of $72.25 in 1999 and the company posted a $428 million loss.

Caplan slashed the company's marketing budget - E*Trade gained Madison Avenue notoriety under Cotsakos with Super Bowl ads featuring a dancing chimpanzee and a message that said, "We just wasted $2 million. What are you doing with your money?" He eliminated a plan to build a nationwide network of ATM machines and focused on bringing in deposits with high rates and making loans to the "mass affluent" investors with $50,000 to $500,000 that larger brokerage firms considered too small.

Caplan, who has a law degree from Emory University in Atlanta and an undergraduate degree from Brandeis University, also bought two smaller discount brokers - Harrisdirect from Bank of Monteral (BMO) and BrownCo from JPMorgan Chase & Co. (JPM) - and has made on-again, off-again moves to merge with archrival TD Ameritrade. And he moved the company's headquarters from its dot-com roots in California to New York City.

Wharton's article praised the CEO's "laser-like focus on exactly who the potential customers of E*Trade Financial are and what financial services they are likely to need."

Investors, however, can expect more write-offs, Citigroup analyst Bhatia wrote Monday. More than half of E*Trade's home equity portfolio is made up of loans with less than full documentation and loans made in 2006 and 2007, when underwriting standards collapsed. The company's CDO portfolio, Bhatia said, is "relatively low quality."

"The extent of poor risk management in our view, has put the viability of the franchise at risk," Bhatia wrote.

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